Article written by Francesco Dagnino, Angelo Messore and Carlo Giuliano (LEXIA Avvocati)
What happened to Luna has been one of the worst downfalls in the crypto history. The value of the project Terra tokens – Luna and TerraUSD (UST) – dropped dramatically in a few hours, with the market value of other cryptocurrencies falling significantly as well. Many investors have lost a huge amount of money. The trading of UST was blocked by several platforms, while the developers of the Terra project were working to stabilize their tokens.
What are Luna and UST?
Luna and UST are the tokens used for the functioning of the Terra blockchain.
Terra blockchain is a public blockchain protocol supporting a wide range of DeFi, NFTs and Web3 projects.
UST is an algorithmic stablecoin whose value is pegged 1:1: to the US Dollar. Being an algorithmic stablecoin, the value of UST is not backed by any asset (such as fiat money), but the peg works on the basis of an algorithm. The algorithm should ensure that the value of the coin is kept stable by balancing the supply of the UST considering any changes in the demand.
Luna is a volatile token which is used by the smart contracts of the Terra protocol to maintain the value of UST stable through minting and burning. Even if the value of Luna may fluctuate, it should always be tradable against UST at the value of 1 US Dollar.
Why did UST lose its value?
UST was largely used in the DeFi world. Investors could deposit their UST on DeFi platforms, thus providing the necessary liquidity to the liquidity pools, and earn passive income through yield farming.
Following massive withdrawals from Anchor Protocol and Curve (two DeFi platforms where UST was used) the value of UST plunged and broke the peg with the dollar. The protocol behind UST reacted using the Luna token, whose market value also suffered a significant shock.
Should we blame on the lack of regulation?
Several commentators argued that the UST downfall occurred because stablecoins are not regulated, and that regulation could (and should) have prevented this to happen.
When it comes to stablecoins, there is a clear and important difference between asset-backed and algorithmic stablecoins. While algorithmic stablecoins such as UST rely on an algorithmic mechanism to keep their price stable, asset-backed stablecoins are collateralized through fiat money or other underlying assets.
Neither of the two stablecoins is regulated under the existing EU rules. European Institutions are working on the Regulation on Market in Crypto Assets (MiCA), which is purported to provide a comprehensive framework for the offer and trading of cryto-assets in the EU.
The MiCA Regulation mainly focuses on asset-backed stablecoins, by imposing certain authorization and other requirements on the issuers of e-money tokens and asset-referenced tokens. Algorithmic stablecoins are kept outside the scope of MiCA “provided that they do not aim at stabilizing their value by referencing one or several other assets” (Recital (26) of the MiCA Regulation).
The Luna case made it clear that algorithmic stablecoins can pose significant threats to the stability of crypto-markets (and possibly of financial markets in general). Some people even argued that algorithmic stablecoins should not be treated as “stable”-coins, because there is nothing “stable” in relying on an algorithm to ensure that the value of the coin does not fluctuate.
Re-thinking the regulatory approach to stablecoins
European institutions and lawmakers in general should look at the Luna case closely to understand what went wrong and how regulation could address algorithmic stablecoins.
The crypto industry has been violently shaken in the last days and the market confidence in stablecoins and cryptocurrencies in general has dropped. The introduction of a clear regulatory framework governing algorithmic stablecoins could restore the market’s trust and support the growth of the DeFi ecosystem.
The MiCA will introduce strict requirements for the issuers of algorithmic stablecoins qualifying as e-money tokens or asset-referenced tokens, but there might be loopholes deriving from the principle enshrined in Recital (26) of the Regulation. In the absence of a common regulatory framework in the EU, national governments may decide to introduce their own legislative measures on algorithmic stablecoins, which could lead to a fragmentation of the EU market for crypto-assets.
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